Monday, 15 August 2016

MMT vs the bond market

Why do governments borrow from the bond
market? Is there a better way for governments to finance their deficits than
this? If so, what economic factors should determine where governments need to
look for finance? These are questions that I have been asking myself over the
past few months and years, but I seem to be in a minority. Certainly most
mainstream economists don't seem to be that bothered, but I think they should
be because it is becoming pretty obvious that the old ways don't work any more.

This week the Bank of England cut interestrates to 0.25% and embarked on a new wad of quantitative easing (QE) in a bid
to head off recession. Now I pointed out a few years ago that lowering interest
rates to near zero will have practically no effect on stimulating extra demand
for credit and so will not create new demand via increased consumer spending in
the real economy either. Only a fiscal stimulus will do that but this
government has set itself against doing anything that remotely resembles
Keynesian interventionism. But as I pointed out last time, even governments
that are supposed to believe in Keynesian economics have consistently failed to
apply sufficiently large fiscal stimuli during major recessions.

Yes they increase welfare spending, but
only because unemployment has increased and that has forced their hand. Meanwhile,
they compensate by cutting spending in other areas to try and minimise total borrowing.
These cuts often further increase unemployment and lower GDP. This leads to the
austerity that we have been familiar with over the last eight years, and while welfare
spending has still increased, it has often been undertaken grudgingly and
parsimoniously. Consequently, while government spending increases, it does not
increase fast enough to reverse the effects of the recession. The result is the
recession is longer and deeper than it needed to be and chancellors like George
Osborne continuously miss their deficit targets.

So while the government may claim that
their actions are Keynesian because they are increasing spending and borrowing
in the recession, their actions cannot in any way be considered to be within
the spirit of Keynesianism because they make no attempt to restore the economy
to full employment or maximum output. But this failure to adhere to Keynesian
orthodoxy is not totally ideological. As I pointed out previously, the last
Labour government was almost as obsessed with deficit reduction post-2008 as
the Tories have been. What drives this fiscal trepidation is fear and loathing
about debt. In the aftermath of the 2007 crash the worry was all about debt to
GDP ratios and sovereign default. We were bombarded with threats to our credit
rating from the very credit agencies that partially created the financial
crisis in the first place. We were told that if we borrowed too much we would
end up like Greece. But all this was bogus economic scaremongering for two
reasons.

Firstly, unlike Greece we had control of
our own currency, and secondly all our debt was denominated in our own
currency. No developed country has ever defaulted on its sovereign debt when
that debt has been denominated in its own currency. But there is another more
important point that needs to be appreciated when it comes to sovereign debt.
Who you borrow from matters just as much as, if not more than, how much you
borrow.

To see this consider these two examples.
Greece currently has a debt to gdp ratio of 180%. As a result most economists
consider Greece to be essentially bankrupt and incapable of paying back what it
owns. Most expect it to default sooner or later. Japan on the other hand has an
even higher debt to gdp ratio of 230% but no-one expects Japan to go bust. Why?

The answer is because Greece owes virtually
all its debt to foreign creditors (ECB, IMF, German and French banks) in a
currency that it cannot print, cannot control, and cannot devalue. Even if
Greece left the euro its new currency would devalue and its economy shrink
relative to its economic competitors, but its debt would not. So its debt to
gdp ratio would skyrocket even further.

Japan's debt on the other hand is owned
mainly by its own citizens and domestic banks and corporations and is also
denominated in its own currency. The Japanese government can never fail to
repay its debts because it can always raise taxes on the people it owes money
to in order to pay them the money it owes them. As a result it can never run
out of money and the money it pays out in interest and maturity repayments
never leaves the Japanese economy. The only risk to the Japanese government is
loss of confidence by the public in the government and a rush to liquidate the
bonds they hold, but this can be avoided in two ways. Either the government can
impose fixed maturity dates on the bonds or savings, or it can borrow from
itself in the form of its central bank (like QE). This latter mechanism is the
essence of what is known as modern monetary theory or MMT, which I will discuss
further in a future post, and what this and previous posts are intended to
provide the justification for.

What this shows is that when it comes to
national debt, borrowing from within your own currency area is more sustainable
than borrowing from outside it. In short, countries that borrow internally
instead of externally from the bond market can never go bust. This is one major
reason why countries should shun the bond market, but there are other good
reasons as well.

Every time a government borrows from
overseas it is adding to the current account deficit. The UK gilts created are in
effect exchanged for foreign currency which can then be used to purchase
additional goods from overseas. This happens without an equal amount of
production having taken place inside the UK and then exported. Alternatively,
the foreign currency is first converted to sterling in order to buy the gilts,
thereby leading to a strengthening of sterling on the currency markets. Neither
of these effects is desirable.

So what is clear is that conventional methods
of government borrowing come with a significant sting in the tail, and yet as
QE has shown, these stings are often unnecessary and could be avoided. So why
does most of the mainstream economic community not appear to get this? Why
don't they recognise that there might be better ways for governments to finance
their deficits and to run the economy?

Well one reason that they continue to use
the bond market is perhaps because that is what they have always done. In the
times before fiat currency and free flows of capital governments needed to
physically borrow other people's money in order to spend it. Money creation was
not possible. But I think there is a deeper problem. Economists don't think
like physicists. A physicist will always tackle a problem by simplifying it to
its core. This means first considering a closed system problem and then looking
at system leakage as a perturbation to that initial system. Economics on the
other hand seems obsessed with open systems, globalisation and free trade.

What I think MMT could do is allow a
government to more effectively internalise its economy and protect its currency.
It could enable it to borrow unlimited funds (from its own central bank) in a
recession in order to enact a proper Keynesian response to a financial crisis.
This in turn could be used to fund investment, job creation or helicopter money
which would be far more effective than cutting interest rates to zero or
providing QE for banks. The result could be much greater macroeconomic control
and shorter and shallower recessions.